The days of the cyclical energy insurance market operating with the predictability of the past may be gone, says Peter Stow.

Those players who are expecting the current soft market to harden in the foreseeable future may have a long wait ahead since market dynamics and longer term structural changes are helping to shape a brave new insurance world.

Capacity will remain high and premium rates unlikely to return to the extravagantly high levels of the early 1990s.

A hard market is unlikely to occur without a capacity shortage. The energy insurance market remains beset by over-capacity, resulting from a combination of low loss levels, sustained profits and a strong global economy, Worldwide capacity for both onshore and offshore property risks now stands at record levels, up from last year by 9% for offshore and by a significant 33% for onshore exposures. With onshore and offshore property showing capacities of approximately $4 billion each, when the majority of clients need less than $1 billion, a colossal 70% of surplus capacity needs to go before a hard market can re-emerge and this is not readily going to happen due to a number of factors:

Reduction in demand for insurance products due to:

* The most depressed oil and gas prices for over 20 years, leading naturally to a reduction in capital spending. The opening of new markets, for example the $100 billion European gas market agreed by the European Union to be phased in over the next decade, is likely to ensure that these prices stay low.

* New technologies creating less focus on single, high valued units that require significant insurance capacity. Many of the more recent developments in the energy sector have involved a greater number of units with lower individual values.

* The acceleration of energy industry consolidation causing a better spread of production throughout the world thus obviating the need for high levels of business interruption coverage.

* New technology making it feasible for companies to replace existing production facilities at well below the original cost of construction, thus reducing sums insured as well as the need for high loss limits.

* A fundamental shift towards self-insurance through the use of captives. Improvements in risk financing techniques mean that many companies are willing to accept much higher retention levels and, consequently, reduce the amount of insurance purchased to protect their assets. Paradoxically, underwriters encouraged this shift in the early 1990s by increasing rates to unsustainable and unjustifiable levels.

With the exception of a tiny minority of exposures (for example, the very largest offshore platforms), there is no area of the energy risk portfolio that requires the capacity levels now available. Even if the most prudent assessments are used to determine amounts at risk (for instance, full value for onshore property or the value of entire, bridge-linked complexes for offshore property), the vast majority of risk managers now have a plethora of leading underwriters and world-wide markets from which to choose their underwriting security.

Fuelling further capacity

The market manifestation of excess capacity and subsequent intense competition for market share and market domination is in itself leading to further capacity.

Taking advantage of the current competitively priced reinsurance rates to absorb any exposures which they would prefer not to retain, many underwriters are maximising their participation across all segments of the energy portfolio, in order to generate as much premium income as possible and compensate for the prevailing low premiums, This contrasts with the hard market peak of 1993 when underwriters enjoyed a surplus of business and could afford to reserve the bulk of their underwriting stamp for the more profitable elements of the portfolio.

To further respond to today's intense competition, insurers are forming larger and more financially secure units, with concentrated capabilities, through mergers and the consolidation of onshore and offshore capabilities. These can deliver capacity for all lines of energy business (cross-class), thereby providing a degree of long term balance sheet protection for the widest range of risks.

Underwriters are still making profits despite the spectacular decline in rates over the last five years, and new players are still being attracted to the market. Such profits are due to the combination of the low loss record and availability of facultative and portfolio reinsurance at favourable rates.

Even if the loss ratio were to worsen and, indeed, the statistical chances of a catastrophe or series of major losses occurring are increasing with the passing of each year, low cost reinsurance and attractive interest rates could still enable underwriters to make a profit.

Reinsurance markets

The reinsurance markets are currently even softer than the direct energy market. Again, the same factors come into play - a lack of catastrophe losses, continuing profits and abundance of capacity. These markets are offering protection to the direct energy markets on a quota share and excess of loss reinsurance basis. Losses are beginning to filter through to reinsurers but not at a quantity or size which will readily affect the market.

In addition to the portfolio reinsurances, many markets are also availing themselves of highly competitive facultative primary reinsurance. There appears to be a never ending supply of markets from Australia and North America that are willing to write this class of business at least for a period of time. Some of these primary markets have begun to suffer high losses during 1998. However, as they withdraw from the class, others appear to be lining up to take their place.

There is, therefore, no suggestion at this stage that the competitively priced abundance of reinsurance capacity, that is to some degree propping up the direct market, is likely to disappear in the immediately foreseeable future. The vast majority of underwriters will remain in the market, thus sustaining capacity.

Some commentators have noted that many underwriters' premium bases are now too low to withstand a serious loss. Much of the current capacity is composed of major insurers of excellent financial pedigree whose long-term commitment to the energy sector could weather even a fairly sustained period of either attritional or catastrophic losses.

Several underwriters with capacities of $25 million or less are having difficulty in competing successfully with the larger insurers, and may have to withdraw from the energy sector if the current situation continues or deteriorates any further. However, their withdrawal would be unlikely to have much impact in view of the current degree of over-capacity.

Very few underwriters of any stature are, at this time, indicating the possibility of withdrawal from the sector. This is understandable in the light of the profits that are still being made and the current conditions of the reinsurance market.

There are also other factors involved, not least the determination of some underwriters to continue to participate in the hope that the market will turn. Many leading underwriters feel that they cannot afford to surrender their current market position today for fear of missing out on the next era of underwriting profit. A vast amount of capacity would have to be eliminated for there to be any effect whatsoever on direct rating levels. Believers in the market cycle, who are staying around in anticipation of a hard market, are simply contributing, ironically, to sustaining the soft market.

Effect of ART

However, there may be a more fundamental change in the nature of the market which will contribute to maintaining premiums at a low level, even if all other traditional factors suggest the inevitability of a hardening of the market in years ahead. This fundamental element is the emergence of alternative risk transfer (ART) mechanisms - products provided by and derived from the capital markets, such as non-indemnity based financial triggers, securitisation, bonds and other sophisticated financial tools, self-insurance and greater use of captives.

These mechanisms are already developed and waiting in the wings, and could become financially more attractive if premium rates begin to increase, thus posing a serious threat to the current energy market place. Underwriters may be forced to hold rates down to fend off this competition.

Although rates are not likely to increase in the immediate future, alternative risk transfer mechanisms are a real threat and this factor could act as a powerful deterrent to underwriters who would like to see rates harden. The market is unused to outside competition which has not played any meaningful role in the energy sector since the formation of the petroleum industry mutual O.I.L. in the early seventies.

To fend off this competition successfully, underwriters will not only need to be wary of any undue increases in rating, they will also need to develop new products themselves. Some forward thinking insurers have already started to break away from the herd mentality that characterises the underwriting cycle by making demand for their products less prone to price elasticity, and supply more flexible.

For example, Swiss Re's Beta product provides $300 million of limit and is designed to combine property and liability coverage over a three year term, with an option of extending for another three year term at predetermined rates; XL and Cigna's "Risk Solutions" product offering combined aggregate limits of up to $400 million and term limits of up to $1 billion for multi-year programmes.

These examples also evidence a willingness to offer long-term three to five year fixed price policies in order to try and provide risk managers with the long term stability they seek. Several major insurers have the financial strength to support this type of product, and some are keen to utilise this advantage to secure a greater market share.

This may only be the start in the development of new products. If underwriters want to avoid losing business and to stabilise demand, they will have to move quickly to develop new products that clients want and do so cost-effectively and efficiently, Traditional underwriters have an advantage over their would-be competitors in that they already have the business and understand the risk. Additionally, underwriters, unlike other financial institutions such as banks, are not risk averse, which is what many clients actually need.

Underwriters who develop these new products will succeed in maintaining their share of the portfolio, while those underwriters who bury their heads in the sand and rely on the return to a hard market may find that their portfolio diminishes rapidly.

Conclusion

The conclusion that must be drawn from the present state of the energy insurance market is that current market manifestations should not be mistaken simply for the operation of the traditional insurance market cycle. Longer term structural changes are clearly evident, and these could lead to the prospects of boom or bust insurance cycles, so typical of the past, being dramatically reduced for the future.

Change is likely to be evolutionary rather than revolutionary, but the reality is that we are entering a period that has no historical precedent and there can be no doubt that the future holds exciting challenges.

Peter Stow is deputy chairman marine and energy, Aon Group Limited. Tel: +44 (0) 171 623 5500. Fax: +44 (0) 171 621 1511.